economic growththe process by which a nation’s wealth increases over time. Although the term is often used in discussions of short-term economic performance, in the context of economic theory it generally refers to an increase in wealth over an extended period.

Growth can best be described as a process of transformation. Whether one examines an economy that is already modern and industrialized or an economy at an earlier stage of development, one finds that the process of growth is uneven and unbalanced. Economic historians have attempted to develop a theory of stages through which each economy must pass as it grows. Early writers, given to metaphor, often stressed the resemblance between the evolutionary character of economic development and human life—elife—e.g., growth, maturity, and decadence. Later writers, such as the Australian economist Colin Clark, have stressed the dominance of different sectors of an economy at different stages of its development and modernization. For Clark, development is a process of successive domination by primary (agriculture), secondary (manufacturing), and tertiary (trade and service) production. For the American economist W.W. Rostow, growth proceeds from a traditional society to a transitional one (in which the foundations for growth are developed), to the “take-off” society (in which development accelerates), to the mature society. Various theories have been advanced to explain the movement from one stage to the next. Entrepreneurship and investment are the two factors most often singled out as critical.

Economic growth is usually distinguished from economic development, the latter term being restricted to economies that are close to the subsistence level. The term economic growth is applied to economies already experiencing rising per capita incomes. In Rostow’s phraseology economic growth begins somewhere between the stage of take-off and the stage of maturity; or in Clark’s terms, between the stage dominated by primary and the stage dominated by secondary production. The most striking aspect in such development is generally the enormous decrease in the proportion of the labour force employed in agriculture. There are other aspects of growth. The decline in agriculture and the rise of industry and services has led to concentration of the population in cities, first in what has come to be described as the “core city” and later in the suburbs. In earlier years public utility investment (including investment in transportation) was more important than manufacturing investment, but in the course of growth this relationship was reversed. There has also been a rise in the importance of durable consumer goods in total output. In the U.S. experience, the rate of growth of capital goods production at first exceeded the rate of growth of total output, but later this too was reversed. Likewise, business construction or plant expenditures loomed large in the earlier period as an object of business investment compared to the recent era. Whether other countries will go through the same experience at similar stages in their growth remains to be seen.

Comparative growth rates for a group of developed countries show how uneven the process of growth can be. Partly this unevenness reflects the extraordinary nature of the 1913–50 period, which included two major wars and a severe and prolonged depression. There are sizable differences, however, in the growth rates of the various countries as between the 1870–1913 and 1950–73 periods and the period since 1973. For the most part, these differences indicate an acceleration in rates of growth from the first to the second period and a marked slowdown in growth rates from the second to the current period. Many writers have attributed this to the more rapid growth of business investment during the middle of the three periods.

The relatively high rates of growth for West Germany, Japan, and Italy in the post-World War II period have stimulated a good deal of discussion. It is often argued that “late starters” can grow faster because they can borrow advanced technology from the early starters. In this way they leapfrog some of the stages of development that the early starters were forced to move through. This argument is nothing more than the assertion that late starters will grow rapidly during the period when they are modernizing. Italy did not succeed in growing rapidly and thereby modernizing until after World War II. Together with Japan and Germany it also experienced a large amount of war damage. This has an effect similar to starting late, since recovery from war entails building a stock of capital that will, other things being equal, embody the most advanced technology and therefore be more productive and allow faster growth. The other part of this argument is the assertion that early starters are actually deterred from introducing on a broad front the new technology they themselves have developed. For example, firms in a country that industrialized early may be inhibited from introducing a more modern and efficient means of transportation on a broad scale because there is no guarantee that other firms handling the ancillary loading and unloading tasks will also modernize to make the change profitable.

Related to this is the problem of whether or not per capita income levels and their rates of growth in developed economies will eventually converge or diverge. For example, as per capita incomes of fast growers like the Italians and Japanese approach those of economies that developed earlier, such as the American and British, will the growth rates of the former slow down? Economists who answer in the affirmative stress the similarities in the changing patterns of demand as per capita income rises. This emphasis in turn implies that there is less and less chance to borrow technology from the industrial leaders as the income levels of the late starters approach those of the more affluent. Moreover, rising per capita incomes in an affluent society usually are accompanied by a shift in demand toward services. Therefore, so this argument goes, differences in income levels and growth rates between countries should eventually narrow because of the low growth in productivity in the service sector. The evidence is inconclusive. On the one hand, growth is a function of something more than the ability to borrow the latest technology; on the other hand, it is not clear that productivity must always grow at a slower rate in the service industries.

A rapidly increasing population is not clearly either an advantage or a disadvantage to economic growth. The American Simon Kuznets and other investigators have found little association between rates of population growth and rates of growth of GNP per capita. Some of the fastest growing economies have been those with stable populations. And in the United States, where the rate of growth of population has shown a downward historical trend, the rate of growth of GNP per capita has increased over the last century and a half. Another finding by Kuznets is that while GNP per capita in 1960 was substantially higher in the United States than in any European country, there was no significant difference in the per capita growth rates of all these countries over the period 1840 to 1960 as a whole. The conclusion is that the United States started from a higher per capita base; this may have been the result of its superior natural resources, especially its fertile agricultural land.

The analysis of growth

To explain why some countries grow more rapidly than others or why a country may grow more rapidly during one period of history than another, economists have found it convenient to think in terms of a “production function.” This is a mathematical way of relating some measure of output, such as GNP, to the inputs required to produce it. For example, it is possible to relate GNP to the size of the labour force measured in man-hours, to capital stock measured in dollars, and to various other inputs that are considered important. An equation can be written that states that the rate of growth of GNP depends upon the rates of growth of the labour force, the capital stock, and other variables. A common procedure is to assume that the influence of the separate inputs is additive—iadditive—i.e., that the increase in the growth of output caused by increasing the rate of growth of, say, capital is independent of the rate of growth of the labour force. This is the starting point of a great deal of current empirical work that attempts to quantify the importance of different inputs.

Under certain assumptions, some reasonable and some patently false, it is possible to conclude that what labour and capital receive in the form of wages, profits, and interest is a fair measure of what they contribute to the productive process. Thus in the United States in the period following World War II the share of output going to labour was approximately 79 percent, while the share of output distributed as “profits” was 21 percent. If we assume that these proportions determine how much we should weight the rate of growth of the labour force and of capital respectively in determining their contribution to the rate of growth of output, we must conclude that the relative contribution of capital is slight. Alternatively, we may say that some given percentage increase in the rate of growth of the labour force will have a much larger influence on the rate of growth of output than the same percentage increase in the rate of growth of capital. This is a puzzling result and can be traced to the assumption that the influence of separate inputs is additive.

Quality improvements in the inputs

Much work has been done in an effort to measure the inputs in the productive process more accurately by taking account of improvements in the quality of both labour and capital over time. For example, it has been argued that the amount of a worker’s time spent on his formal education is positively related to the income he receives and to his productive contribution. Measuring the number of man-hours worked from one period to the next will not give a true picture of the increase in labour input if the average amount of education received by workers is changing. Man-hour units must be converted to “efficiency” units. Thus if a labour force of 100 workers in the first year all had an eighth-grade education, while 20 years later each member had a 10th-grade education, then measured in efficiency units the labour force had grown. If the length of time spent on formal education increases over time, then the growth of the labour input will be larger if measured in efficiency units. There is, thus, an element of capital in the labour force.

Examples of investment in human capital are expenditures on health and on all types of education, including on-the-job training. Expenditures of this sort increase the quality of the labour force and its ability to perform productive tasks. Many economists have argued that technological progress is really nothing but quality improvements in human beings. Some economists take an even broader view and speak of the “production of knowledge” as the clue to technological progress. The production of knowledge is a broad category including outlays on all forms of education, on basic research, and on the more applied type of research associated especially with industry. It is argued that fast-growing industries tend to be those having a high research and development component in their total costs. In addition, firms within an industry that have large research and development budgets tend to experience the most rapid technological progress. The argument is that technical change and improvements must originate in inventions that lead to innovations in the products produced or in the processes whereby existing products are manufactured.

A similar argument applies to the size of the capital stock. It can be maintained that design improvements increase the efficiency of capital goods so that a dollar’s worth of machinery purchased today may be much more efficient than a dollar’s worth of depreciated machinery purchased yesterday. The rate of growth of the capital stock measured so as to take account of quality improvements will be greater than the rate of growth of the capital stock measured in a way that neglects the differences between “vintages.”

Some economists have stressed “economies of scale.” For example, if an increase in the use of capital and labour leads to a greater than proportionate increase in output, this is said to result from economies of scale. Economies of scale may arise because an expansion of the market justifies a radical change in productive techniques. These new techniques may be so much more efficient that the returns in the way of increased output are much greater proportionately than the increase in inputs.

Another source of growth and of technical progress in particular has been seen in shifts of demand from low productivity sectors to high productivity sectors, thus causing resources to be reallocated. The most notable movement has been the shift of resources, especially labour, out of agriculture—a traditionally low-productivity sector. Such shifts act to increase the rate of growth of output in ways that cannot be accounted for by simply measuring growth in total inputs. Historically, the allocation of both capital and labour have shifted during the growth process from low productivity sectors to high ones, causing the rate of growth of output to exceed the weighted average of the rates of growth of total inputs.

Entrepreneurship

This historical fact points to an element that has received little attention so far: the influence of entrepreneurship. If the allocation of resources changes during the course of growth and development, it does so under the leadership of an entrepreneurial class. The quality of entrepreneurship is seen by many economists as an important explanation of differences in the rate of technical progress between countries. Decisions must be made somewhere along the line as to whether a new product or process will be introduced. It has been argued that two countries undertaking similar amounts of investment leading to more or less identical rates of growth in the capital stock will not necessarily show the same rate of technical progress. In one country entrepreneurs may be undertaking enterprise investment that has as its aim the introduction of the most advanced types of production techniques, those that will lead to a rapid growth of labour productivity. In the other, because of hesitation or ignorance, the investment program may lead only to marginal changes in productive processes; the resulting growth in labour productivity and GNP will be small. For example, much has been said since World War II about the more aggressive nature of German businessmen as compared to their English counterparts. The emphasis on the role of the entrepreneur in economic growth stems from the theoretical work of the economist Joseph A. Schumpeter, but many others have echoed it.

The play of influences

Much thinking assumes, then, that contributions to output from growth of individual inputs are independent of one another. This assumption allows many growth theorists to conclude that capital investment is relatively unimportant as a growth factor. If there is interaction between the rates of growth of the different inputs, however, then it is possible to draw different conclusions. For example, over time there are likely to be improvements in the quality of capital goods. A machine that requires so much steel and so much labour to manufacture may be twice as productive as an older machine that required the same amount of raw materials and labour in its manufacture. Thus the rate of growth of technical progress and the rate of growth of the capital stock measured in natural units interact. Furthermore, the interaction between technical progress and capital formation is not necessarily in one direction. New knowledge opens up new production possibilities and gives rise to potential increases in technical progress and profits. Or the better educated the labour force, the more adaptable it is likely to be and therefore the better able to cope with new production techniques. At the same time, the higher the rate of growth of capital, the higher will be the growth of incomes and therefore the demand for education. The fact that much of the overall growth of technical progress stems from the transfer of resources and the positive association between the rate of transfer of resources and the rate of growth of the capital stock is another example of interdependence or complementarity between the growth of the inputs. But, again, capital investment undertaken to develop new lines of production will also be dependent on technological progress going on in those areas.

Conventional marginal productivity doctrine argues that as an input such as capital rises relative to labour, the additional output or marginal product that can be attributed to this extra amount of capital will be less than what a unit of capital on the average had been producing before. Marginal productivity doctrine also assumes that each unit of capital is identical with the next. This assumption is the basis for the argument that as more units of capital are utilized in production with a given amount of labour, it will push down the former’s marginal product. There is the possibility, however, that additional units of capital may enhance the productivity of existing units: for example, an increase in the amount of capital resources devoted to the development of transportation and distribution may raise the productivity of capital employed, say, in manufacturing. The development of this kind of social overhead capital is certainly a prerequisite for a high return to capital in manufacturing, wholesaling, and retailing.

The analysis can be carried back one more step, to the basic determinants of growth. Economists ask why it is that capital, labour, or technical progress has grown more rapidly in one economy than in another or at one time than at another. Historically, the transition from a subsistence-level, underdeveloped state to a higher-level, developed one has been accompanied by a decline in the death rate followed by a decline in the birth rate. This has the effect of first speeding up the rate of growth of the population and labour force and then reducing it as birth rates fall. Migration can alter this picture, often unpredictably. In the United States, for example, the rate of growth of the population and labour force during the 19th and early 20th centuries was higher than in most other developed countries, mainly because of high rates of immigration. From 1840 to 1930, the native-born U.S. population increased about 600 percent, while the number of those of foreign birth increased 1,300 percent.

The role of government

The differences in rates of growth are often attributed to two factors: government and entrepreneurship. The two are not mutually exclusive. In the early stages of sustained growth, government has often provided the incentives for entrepreneurship to take hold. In some economies the development of transportation, power, and other utilities has been carried out by the government. In others the government has offered financial inducements and subsidies. The land given U.S. railroad developers in the second half of the 19th century is a notable example of the latter. Another important role governments have played in the early stages is to help establish the sort of capital and money markets in which lenders could have confidence. Without financial intermediaries acting as brokers between lenders and business borrowers, it is difficult to envisage economic growth taking place on a sustained and rapid basis.

In the 19th century most liberal thinkers held that the main role for government in a developed capitalist system was that of a policeman: to preserve law and order, uphold the sanctity of private property, and give business as much freedom as possible. The Great Depression of the 1930s persuaded many that a laissez-faire system did not automatically provide the necessary incentives to the innovation and risk bearing essential for economic growth. This led to a good deal of writing on the role that governments might play in stimulating growth. Economists have argued that, at the very least, governments can undertake to prevent serious and prolonged recessions. Only in this way can a general business psychology be developed that assumes growth to be the natural course of things, so that investment programs will pay off.

Growth theorists since World War II have gone further, arguing that it is not enough simply to achieve full employment periodically. Some maintain that it is necessary to maintain full employment over an extended period of time if high growth is to result. This argument relates to the earlier point that two economies may experience the same rate of growth of capital but that overall growth and technical progress will proceed at a much more rapid rate in one than in the other because of differences in the quality of new capital goods produced. The term enterprise investment has been used to describe the kind of capital formation that involves innovations and that by building ahead of demand generates rapid rates of growth of productivity or technical progress. But to get such growth, it has been argued, an economy must be run “flat out,” at full speed. While this has been subject to some dispute, there is a fairly general consensus that growth will be faster when unemployment fluctuates within a narrow range and at low levels.

A variation on this argument is the question of how a government may intervene to determine the distribution of output between those types of expenditure that contribute to growth and those that lead to the immediate satisfaction of consumer demand. Here the choice lies between business investment, research, and education on the one hand and consumption on the other. The larger the first three, the more rapid will be the rate of growth. Governments giving a high priority to growth have various means at their disposal for influencing it. Consumption can and has been constrained through increases in income tax rates. The same is true of other tax rates such as the property tax—the chief revenue source for primary and secondary education in the United States. Tax credit for research and development expenditures is a common method for encouraging business outlays that may lead to innovations. The same method has been used to stimulate business investment outlays. “Easy money” policies on the part of the central bank, whereby the cost of borrowed funds and their availability are indirectly regulated in such a way as to encourage business borrowing, may lead to higher levels of real investment.

The true cost of stimulating growth will always be a temporary cut in current consumption. Only in the future can the economic benefits of the higher investment be realized. By the same token, current consumption can always be enlarged by a neglect of the future. It is even possible for current production to be so biased toward the satisfaction of immediate needs that the productive capacity of an economy slowly declines as capital goods are not replaced. Between the extremes of total neglect of future generations and the paring down of current consumption to a bare subsistence minimum lie an infinite number of possibilities.

The social cost of growth

The belief that governments should have a large say in choosing the “right” rate of growth has also led some writers to challenge the social and economic value of economic growth in an advanced industrial society. They attribute to growth such undesirable side effects of industrialization as traffic congestion, the increasing pollution of air and water, the despoiling of the landscape, and a general decline in man’s ability to enjoy the “real” amenities of life. As has been seen, growth is really a transformation whereby certain industries experience a rise in importance followed by an eventual decline as the market for their output becomes relatively saturated. Demand, relatively speaking, moves on to other types of industries and products. All of this naturally implies a reallocation of resources over time. The faster these resources move, other things being equal, the more rapidly can growth and transformation proceed. The argument can be recast in terms of this transformation. A slower rate of growth in per capita consumption will slow down the rate of transfer of resources, but it may also result in a more livable environment. The rate of growth of individual welfare, so measured as to take into account non-consumable amenities, may even be increased. Some argue that in a growth-oriented society wants are created faster than the industrial machine can satisfy them, so that people are more dissatisfied and insecure than they would be if growth were not given such a high value. It is held by some critics that, in modern industrial society, consumption exists for the sake of justifying production rather than production being carried out to satisfy consumer desires. These arguments are a powerful challenge to those who see growth as the most important economic goal of a modern society.

Theories of growth

In discussing theories of growth a distinction must be made between theories designed to explain growth (or the lack of growth) in countries that are already developed and those concerned with countries trapped in circumstances of poverty. Most of what follows will be confined to the former.

As the British economist John Maynard Keynes pointed out in the 1930s, saving and investment are not usually done by the same persons. The desire to save does not necessarily generate investment. If savers attempt to save a larger share of their income than before (thereby consuming less) and if this is not matched by an equal increase in the desire of others to invest, total spending will decline. A natural reaction on the part of business will be to cut back on production, thereby reducing incomes earned in production. The final effect may be a cumulative movement downward as total demand becomes insufficient to employ all of the labour force. This break in the circular flow of income and expenditure suggests the possibility of a capitalist economy alternately experiencing periods of prolonged and severe unemployment (when desired savings at full employment exceed what the economy wishes to invest at full employment) and periods of serious inflation (when the inequality is reversed). This situation had not been the case historically for developed economies until the early 1970s. In the following discussion, some attention will be paid to the ways in which the various theories of growth account for this important historical fact.

Role of the entrepreneur

Modern growth theory can be said to have started with Joseph A. Schumpeter. Unlike most Keynesian or pre-Keynesian theorists, Schumpeter laid primary stress on the role of the entrepreneur, or businessman. It was the quality of his performance that determined whether capital would grow rapidly or slowly and whether this growth would involve innovation and change—ichange—i.e., the development of new products and new productive techniques. Differences in growth rates between countries and between different periods in any one country could be traced largely to the quality of entrepreneurship. The latter in turn reflected certain historical and cultural values carried by the business class. Schumpeter also attributed much of the growth of technical progress and of the supply of labour to the entrepreneur. Thus, in more modern terminology, Schumpeter’s explanation of why demand and supply have grown more or less at the same rate would be that supply adjusted to demand while demand in turn reflected the activities and investments of the entrepreneur.

Schumpeter believed that capitalism by its very success “sows the seeds of its own destruction.” The American economist Alvin H. Hansen argued in the late 1930s that capitalism was in trouble in the United States for other reasons. According to Hansen, the closing of the geographic frontier, the decline in the rate of population growth, and the capital-saving character of recent innovations had all worked to increase the likelihood of stagnation by reducing the need for investment. The savings available in a mature economy would tend to exceed the amount that the economy would want to invest (at levels of full employment) and by progressively larger amounts as time went on. This condition naturally would lead to increasing rates of unemployment as the discrepancy between demand and potential output widened. Hansen’s views were very much coloured by the economic conditions of the 1930s. The record of the three decades after World War II did much to overcome the pessimism generated by the Great Depression.

The role of investment

In Keynes’s General Theory, investment played a key role in that it was presented as the most important factor governing the level of spending in an economy, despite the fact that it typically was only one-fifth to one-sixth of total spending. This paradox can be understood in terms of a concept also developed in the 1930s, the multiplier. The multiplier was the amount by which a change in investment would be multiplied in achieving its final effect on incomes or expenditures. If, for example, investment increases by $10, the extra $10 of expenditures will generate, assuming unemployed resources, an extra $10 of production and subsequently incomes in the form of wages and profit. This increase, however, is hardly the end of the matter since most of the additional incomes earned will be respent on consumer goods. If nine-tenths of any change in income is spent on consumer goods and one-tenth is saved, consumption will increase by $9. But again, one person’s expenditures are another person’s income, so that incomes now rise by $9 of which $8.1 is respent on consumer goods. The process continues until expenditures, incomes, and production have increased by $100, of which $90 is consumption and $10 the original change in investment. In this case the multiplier is 10.

But investment may be a source of instability if it is not maintained at a rate sufficient to stimulate demand for the production it is creating. Is there any guarantee that supply or productive capacity will grow at the same rate as demand so that neither excess capacity nor excess demand results? The British economist R.F. Harrod and the American economist E.D. Domar put this question in a very simple mathematical form. In their equations, the rate of growth of supply (i.e., the production function as defined above) is equal to the rate of growth of capital stock. Through investment this capital stock is augmented. The rate of growth of demand depends upon the rate of growth of investment or, more correctly, upon the rate of growth of nonconsumption expenditures. Thus investment affects both demand and supply. But the Harrod–Domar analysis still did not answer the question of what kept the system from becoming increasingly unstable.

Demand and supply

Much contemporary growth theory can be viewed as an attempt to develop a theoretical model that would bring the rate of growth of demand and the rate of growth of supply into line, since a model implying that capitalist systems are inherently unstable would not correspond to the historical facts. Models of growth may be classified according to whether they emphasize adjustments in demand (supply-determined models) or adjustments in supply (demand-determined models). One of the better-known examples of the supply-determined model was developed by the British economist J.R. Hicks. Hicks assumed that the spending propensities of consumers and investors were such as to cause demand to grow at a rate in excess of the rate of growth of maximum output. This assumption meant that during any “boom” the economy would eventually run into a “ceiling” that, while also moving upward, was moving less rapidly than demand. The long-run rate of growth of the economy would be determined by the rate of ascent of the ceiling, which in turn would depend upon supply factors such as the rate of growth of the labour force and the rate of growth of technical progress or productivity. If for some reason these were to grow more rapidly, then output would also grow more rapidly as demand adjusted upward to the more rapid growth of supply.

An example of a demand-determined model of growth is one developed by the American economist J.S. Duesenberry. In the Duesenberry model, spending propensities of consumers and investors are such as to generate steady growth in demand. Assume that instead of spending nine-tenths of any change in income on consumer goods, as in the multiplier example above, they choose to spend 0.95. This increase will cause the rate of growth of demand to increase. The question is whether it will also cause the rate of growth of production to increase or whether it will merely result in price increases. If productivity or technical progress responds to a higher rate of growth of demand, as Duesenberry assumes, then production can grow more rapidly. Although in both the Hicks and Duesenberry models demand and supply grow at the same rate, the adjustment mechanisms are entirely different. In the Duesenberry model supply adjusts to demand; in the Hicks model demand adjusts to supply.

Other models of growth also illustrate this distinction between demand-determined and supply-determined growth. The British economist N. Kaldor assumed that there is a mechanism at work generating full employment. Simply stated, in his model an inadequate rate of investment will be offset by shifts in the distribution of income between profits and wages, which will cause consumption to change in a compensating manner so that overall demand is unchanged. While there are important differences between the Hicks and Kaldor models, both can be described as models of supply-determined growth.

Another model of supply-determined growth is that implicit in the traditional neoclassical analysis. The mechanism that adjusts demand to growing supply is the price mechanism, or Adam Smith’s “invisible hand” of the market. This type of model assumes a world devoid of monopoly and uncertainty, in which the markets for capital goods and labour are free to adjust quickly so that “markets are always cleared” in the very short run.

A final example of a model of growth that illustrates the problem of adjustment between supply and demand is to be found in the work of the Dutch economist Jan Tinbergen and his followers. In contrast to neoclassical growth models where the market brings about an adjustment of demand to supply, the “target-instrument” models of Tinbergen assume that the government (as in The the Netherlands and other European countries) undertakes to regulate demand and supply in an effort to achieve certain targets such as full employment or a predetermined rate of growth. For example, economists are expected to provide the fiscal authorities with a model that approximates the working of the economy and that indicates what will happen if the government, say, does not change its tax and spending programs in the coming period. These forecasts are appraised in terms of what the authorities consider desirable as a matter of social and economic policy. If it appears that unemployment will be too high and the rate of growth too low, the authorities take countermeasures. The government may, for example, cut taxes on corporate profits in order to stimulate investment. If investment is excessive and there is danger of inflation, the government may take other measures to reduce aggregate demand such as cutting its expenditures. This type of planning procedure has been tried with varying degrees of success. Sweden and The the Netherlands are prominent examples of attempts to offset fluctuations in private spending so as to realize full employment and growth. It should be noted that these models do not fit neatly into the demand-determined or supply-determined classification. In the example just given, both the rate of growth of demand and the rate of growth of supply are effectively determined by the fiscal authorities.

Economic stagnation

The rise in unemployment rates and the slowdown in growth rates of GNP and per capita incomes throughout the capitalist world beginning in the early 1970s is clearly a case where demand and supply did not grow at similar rates. Many economists turned their attention to developing theories to explain this prolonged period of stagnation. A common theme in much of their work was the adverse effects of high unemployment and low utilization of the capital stock on investment and, therefore, on productivity growth.

The high unemployment rates for labour and capital are initially traced to policies restricting aggregate demand that were pursued by monetary and fiscal authorities from the first half of the 1970s. This policy response was widely interpreted by economists as an effort by the authorities to reduce inflation rates that had begun to accelerate in the latter 1960s. The continued use of restrictive policies is then related to fear on the part of the authorities that any attempt to restimulate their economies would merely bring back inflation.

Tighter labour markets resulting from any such stimulative policies are seen to increase the bargaining power of labour, thereby leading to larger wage demands and settlements that in turn feed into prices, causing price inflation to accelerate. This leads to yet higher wage demands in order to protect real wages and thus an explosive wage–price spiral. In addition, more stimulative aggregate demand policies are perceived to result in balance of payments difficulties at existing exchange rates. But any attempt to avoid larger payments deficits by reducing the exchange rate leads to the “importation” of inflation through higher prices of imported goods. The result of such considerations is reluctance of the authorities to attempt to create full employment through stimulative policies.

What emerges from these theories is a chain of causation that describes the way in which, in the period since World War II, inflation and growth have become causally connected through the responses of governments to actual and anticipated inflationary pressures. Inflation and the fear of inflation lead to slow growth and high unemployment because the inability of governments to bring inflation under control at full employment by other means—emeans—e.g., an income policy—constrains governments to implement restrictive policies to combat or forestall inflationary pressures. Such responses lead, as they did in the early 1970s, not only to high rates of unemployment of capital and labour but also to low rates of investment and productivity growth. Stagnation is the result, and such a scenario is a likely prospect for capitalism in the future.

Foreign trade

Little has been said about foreign trade. Yet growth in most economies is very much dependent upon imports and the ability to export in order to pay for imports. The fact that some economies recovered relatively quickly from World War II and grew much more rapidly in the postwar period than others has stimulated a great deal of comparative analysis in growth theory. The exceptionally high growth rates in Japan and Germany compared to the general sluggishness of the British economy are related to foreign trade. Economists have pointed to the periodic balance of payments crises experienced by Britain and the lack of such crises in Germany. During a boom, as incomes rise the demand for imports will rise also as a natural feature of prosperity. But if exports do not also rise at the same time, the authorities may be forced to take fiscal or monetary countermeasures and slow down the economy in an effort to bring imports and exports back into balance. Or exports may fail to grow sufficiently because labour costs are rising very rapidly and pushing up prices of exports faster than in competing countries.

A policy of encouraging growth has the effect of keeping the demand for imports high and making labour markets tight, thereby tending to push up money wage rates. At the same time, such a policy also tends to encourage innovations and investment projects that are very productive, particularly if the demand pressures are sustained. A “stop” policy naturally has just the opposite effects, both good and bad from the point of view of a country’s balance of payments. The question is which policy will in the long run result in less rapidly rising costs and prices. Many writers have argued that if demand pressures are maintained the response or adjustment of productivity and therefore of supply to these pressures will be such that the country will soon find itself in a more competitive position. Running an economy “flat out,” however, is likely to cause a short-run balance of payments crisis and lead to devaluation of currency.

Mathematical growth theories

In addition to the theories discussed above, a large body of literature has developed involving abstract mathematical models. Because this field of analysis is so technical, only a general picture of the kinds of problems and questions discussed can be given. First, a set of equations is drawn up describing what the model builder feels are the important relations between economic variables such as output, capital, investment, and consumption. These equations must relate economic variables to one another at different points in time: for example, output last year determines consumption this year, which in turn helps to determine output this year and therefore consumption and output next year. It is possible to work out the movements of the variables over as long a period as desired. At the centre of much of this analysis is the concept of a steady-state rate of growth: one in which all the economic variables contained in the set of equations grow at the same constant rate equal to the growth of the labour force.

A related class of studies attempts to take account of the welfare of workers and consumers in the maximization of growth. These “optimal growth” models seek to maximize consumer satisfaction over time. In a model such as this the solution will not be the highest possible growth rate but one that will maximize the welfare of consumers. The importance of such models for planners would seem to depend on the realism of their assumptions as to consumer desires and technology.

Model building and theorizing about growth has proceeded on various levels of abstraction. Some of the work is of little practical value, in the sense that its explanatory value is negligible. Such studies, however, may stimulate other work that is helpful in an understanding of the growth process. Some models, while realistic, are not applicable to all economies. Thus, a model that neglects international trade is of little use to a European economist trying to understand the more basic causes of differences in growth rates between countries.

Simon Kuznets, Capital in the American Economy: Its Formation and Financing (1961), a description of trends in capital formation in different sectors of the American economy from the mid-19th to the mid-20th century; W.W. Rostow, The Stages of Economic Growth, 2nd ed. (1971); Ezra J. Mishan, The Cost of Economic Growth (1967), a critique of rapid economic growth as a policy goal; John Kenneth Galbraith, The Affluent Society, 4th ed. (1984), a critique of modern capitalism written for the layman; Joseph A. Schumpeter, Business Cycles: A Theoretical, Historical, and Statistical Analysis of the Capitalist Process, 2 vol. (1939, reprinted 1982), a pioneering work in the field of growth and cycles that stresses the importance of entrepreneurship; and James S. Duesenberry, Business Cycles and Economic Growth (1958, reprinted 1977), a theoretical study of a developed economy of the American type, with emphasis on the importance of demand in growth. Later studies include Dan Usher, The Measurement of Economic Growth (1980), an explanation of the difficulties inherent in such measurement; John Cornwall, The Conditions for Economic Recovery: A Post-Keynesian Analysis (1983), an analysis of the causes and consequences of economic stagnation; Martin Ricketts, The New Industrial Economics: An Introduction to Modern Theories of the Firm (1987), stressing the role of entrepreneurship in modern economics; and on government intervention, Stephen Wilks and Maurice Wright (eds.), Comparative Government-Industry Relations: Western Europe, the United States, and Japan (1987).